Letter to the Editor: Banks are highly capitalized and should not be restricted from making capital distributions for reasons unrelated to safety and soundness

25 Jun 2018

Letter to the Editor Submitted to Bloomberg View on June 28, 2018:

The Financial Services Forum, which represents the eight largest and most diverse financial institutions in the United States, takes issue with a number of assertions in a recent Bloomberg editorial (“Bloomberg View: The Fed Needs to Pass Its Own Stress Test”).  Following the release of this year’s DFAST stress test results, the Bloomberg editorial board suggested 1) the stress tests are not conservative enough, 2) our member banks are too thinly capitalized and, 3) the Federal Reserve should not allow our members to make capital distributions consistent with existing capital requirements.  These claims are incorrect and promote a fundamental misunderstanding of the goal of capital regulation.  Finally, the editorial frames the issue of returning capital to shareholders in a misleading way that injects more confusion than clarity into an important policy discussion.

This year’s stress test is extremely conservative and includes an economic downturn that is worse than previous years’ stress tests and the 2008-2009 financial crisis.  As the editorial rightly noted, this year’s scenario has unemployment rising by 5.9 percentage points and the stock market declining 65 percent.  In contrast, during the financial crisis unemployment rose by 5.6 percentage points while the stock market, as proxied by the market index used in the stress test scenario, fell 57 percent.

Our member banks maintain strong capital levels that have been built consistently over the past several years.  As of the fourth quarter of 2017, the starting point for this year’s stress test, our members maintained an average tier 1 common equity risk-based capital ratio of 12.7 percent, compared to 6.9 percent in 2008.  Further, more than 85 percent of tier 1 capital is comprised of common equity, which is the purest and most loss-absorbing form of capital.

Instead of appropriately focusing on risk-based capital, the editorial selectively referenced the leverage ratio, which is widely recognized as a backstop to more relevant risk-based measures.  To focus on leverage ratios alone—which also are significantly higher for our institutions than they were before the crisis–without any recognition of risk is misleading.

The editorial cites a report by the Federal Reserve Bank of Minneapolis that proposes risk-based capital requirements as high as 24 percent and leverage requirements as high as 15 percent.  This study is an outlier and sits far apart from the consensus view of economists on the appropriate level of bank capital.  Research conducted by the Basel Committee on Banking Supervision in 2010 concluded that the level of bank capital consistent with balancing costs and benefits lies in the range of 9 to 15 percent.  The findings of the Basel Committee are taken seriously because they were reached by a broad group of macroeconomists and capital experts from central banks around the world.

The editorial concludes by suggesting that even though banks maintain risk-based and leverage capital sufficient to withstand a worse-than-financial-crisis scenario, the Federal Reserve should further restrict banks’ abilities to return capital to shareholders.  This is preposterous.  Our member banks maintain capital in excess of 1) risk-based capital requirements, 2) leverage-based capital requirements, and 3) stress testing requirements, which are all designed to rigorously assess capital adequacy.  Therefore, there is no financial stability or safety and soundness rationale for restricting capital distributions over and above the requirements of this trio of capital rules.

Our members have also built substantial amounts of liquidity over the past several years, comply with various other prudential standards, and are subject to a stringent supervisory regime.  As a result, our members are even more resilient than suggested by adherence to the existing trio of capital standards alone.

Finally, the editorial characterizes capital distributions to shareholders as returning “too much” capital to shareholders because banks are paying out “too high” a proportion of earnings to shareholders.  What matters, however, is the quantity and quality of capital that remains on the bank’s balance sheet after the capital distribution is made.  It is misleading to focus on the fraction of earnings going outside the bank rather than the quantity and quality of capital that remains inside the bank.  This misdirection detracts from an important conversation about the level of capital that is required to promote financial stability while also allowing banks to attract capital.

A capital regime that restricts capital distributions for reasons unrelated to safety and soundness will shake investor confidence and reduce banks’ ability to attract capital.  In that event, banks will be less able to provide credit and support economic growth, which is itself a very real financial stability risk that should be more broadly recognized and avoided.

Investors put their money at risk today so that they may benefit from their investment in the future.  A capital regime that restricts capital distributions for reasons unrelated to safety and soundness will shake investor confidence and reduce banks’ ability to attract capital.  In that event, banks will be less able to provide credit and support economic growth, which is itself a very real financial stability risk that should be more broadly recognized and avoided.

Kevin Fromer

President and CEO, Financial Services Forum